Excited about discovering a share with low PE or book value multiples? Beware because it could be a ‘value trap’. Value investing is popular, but it can also lead to traps.
A value trap is a stock or asset that seems to be cheaper as it has been trading at low P/E (low price to earnings), P/CF (price to cash flow) or P/B (price to book value) for a long time.
Value traps can be challenging to spot, but due diligence can help to avoid them. If one takes the time to understand a company and its business, one can protect themselves from these risky investments.
Every company's management declares its short-and-long-term goals. However, they often fail to live up to their promises. Over-promising and under-delivering are key indicators that the investment is a value trap.
So, how does one avoid it?
For instance, the management of Suzlon kept promising a better future for its shareholders, who had been losing money for more than a decade when the stock’s CAGR returns were 7-10% negative over 5-10 years.
A value trap could also be a company whose cash flow isn’t in line with earnings or is suffering from suboptimal earnings growth.
For example, in the case of Bosch, the growth in OCF/FCF in the last 10 years is far lower than the PAT growth, which in itself is just 1% resulting in a stock price CAGR of just 6%.
Another crucial indicator of a value trap is inefficient capital allocation. It means that the company is not using its capital in a way that will generate shareholder value.
For example, a company may allocate funds towards unrelated diversification or non-core businesses. This is unhealthy for Return On Capital Employed (ROCE).
Over time, it was saddled with debt and had to sell its entire stake to Telenor. LIC Housing Finance had lent as high as 7% of its overall loans to the project loan segment, whereas other better-managed HFCs have kept this at sub 1%.
Over-dependence on a particular product or market cycle is one of the most significant signs of a value trap. If a company relies too heavily on one product or market to stay afloat, it may run into trouble in the future if the demand for that product begins stagnating or falling.
An industry that was once booming could eventually become stagnant.
Falling market share is one of the chief indicators of a value trap. If a company loses market share to its competitors, it may be in trouble as its consumers could be moving away.
Falling market share and declining sales margins can also signify that a company is losing its competitive edge.
There are a few ways to avoid value traps. First, research the company thoroughly before investing. Understand the industry it is in and its competitive landscape. Next, look at the financials and make sure they are strong.
The historical performance of a seemingly valuable opportunity or its industry peers or other names displaying similar attributes in the past but turning out to be duds should give enough confidence of which way this one could turn out to be.
Also, pay attention to what the key management personnel are doing. If they are selling their shares without any apparent reason, it may be a sign that the company is not as healthy as it appears.